Financing decision is concerned with the decisions about how much funds are to be raised from which long-term source, i.e. by means of shareholders’ funds or borrowed funds.
Shareholders’ funds include share capital, reserves and surplus and retained earnings, whereas, borrowed funds include debentures, long-term loans and public deposits.
Factors affecting financing decision :
The cost of raising funds from different sources are different. A wise finance manager opt for the cheapest source of finance.
The risk associated to each of the source is different. The source which involves least risk should be preferred.
- Floatation Cost
If the floatation cost, i.e. the expenses incurred in issue of debt is higher, the source of finance becomes less attractive.
- Cash Flow Position of the Company
A stronger cash flow position may make debt financing more viable than funding through equity.
- Fixed Operating Cost
If a firm is having a higher fixed operating burden like payment of interests, premiums, salaries, rent, etc, then it should avoid financing through debt. This is because it will further increase the interest payment burden and the firm can reach an unfavourable position. However, if the firm has lower operating cost, then the firm can borrow funds.
- Control Considerations
Issue of more equity may dilute shareholders’ control over the business. Therefore, a company afraid of a takeover bid may prefer debt to equity.
- State of Capital Market
If the stock market is rising, then it is easy to sell equity shares. But in a depressed capital market, the company has to opt for debt financing.
- Return on Investment (RQl)
Return on Investment means the earnings of a company on its investments. It is an important criteria for deciding the type of funds to be sourced.
When the RQI is more than the cost of debt, (i.e. interest to be paid on debt,) borrowed funds should be used. The reason being:
(t) Interest paid on debt is deductible from profits while calculating tax liability.
(it) It increases the returns of the shareholders. This can be explained by following example
- Tax Rate
Since interest is a deductible expense, cost of debt is affected by tax rate. If the tax rate is higher, debt , financing becomes more attractive.
Financing should be done in such a way, that it should be able to cater to additional requirements of funds in future. If a company uses its debt potential in full, it will lose flexibility to issue further debt, which might become necessary at some future point.
- Regulatory Frame Work
The Companies Act and SEBI guidelines must be observed while raising funds from the public. Government has laid down certain norms for debt equity ratio and ceilings on public deposits. Borrowings from banks and other financial institutions, require fulfillment of certain norms. Thus, the relative ease with which their procedures ’ and norms can be met, has an impact on the choice of the source of finance.